Why Fuss over RMB Depreciation?

August 28 , 2015

The sudden fall of the RMB exchange rate to the US dollar last week shocked the world stock markets and caused strong repercussions in world media. A number of Asian currencies including the Singapore dollar, Korean Won, Vietnamese dong and Malaysian ringgit fell immediately. The shock also extended to Africa as the South African rand was devalued. Wall Street Journal commented on August 17 that RMB devaluation had frightened Chinese African partners. US Senator Robert Casey has even urged the Obama Administration to label China as a currency manipulating country.

However, a more professional comment by Alan Greenspan favored the Chinese central bank's recent move, regarding it an active step toward a market-oriented exchange rate mechanism, during his speech at the Brookings Institution on August 17.

An Over-Valued RMB Finally Came to Its Real Market Value

Before the latest move, the People's Bank of China had set the daily parity rate for RMB at around 6.11 to the dollar for months. However, the actual exchange rate on the offshore exchange market was lower than 6.20, showing a clear over-valued official parity. On August 11, the Chinese central bank lowered its parity from 6.1162 of the previous day to 6.2298, or a straight 1.8% devaluation, based only on the actual market trading level of the previous day, which was around 6.22. The market fell again that day to below 6.30, showing the fact that the actual exchange value should be even lower. On the following day, the central bank set the parity rate at 6.3306, again based on the actual market value. The parity fell slightly further on the third trading day to 6.4010, and then quickly stabilized at 6.3915-6.3975 for the following five trading days until August 20, with an accumulative fall of 4.5% to the dollar, more or less reflecting the current RMB market level. It also shows that, the previous RMB exchange rates were overvalued, due to an inadequate market base.

As the RMB stabilized at a new level to the dollar, the world stock and exchange markets will most likely return to normal next week.

The recent RMB fall has been the result of a significant step forward in its exchange-rate formation mechanism, towards a fully market-based one, minimizing the policy distortion. Such has been the requirement of the IMF, and of the US government as well.

More a Dollar Issue, rather than a RMB Issue

The exchange rate to the US dollar, while serving as the benchmark for the RMB exchange-rate level, is not however, the official measurement of its devaluation or revaluation. The official measurement is RMB's real effective exchange rate (REER) to a basket of currencies, set by Bank for International Settlements (BIS). Over the recent years, RMB REER has been too high and could not be sustained.

REER of major currencies

RMB US Dollar Euro Yen B Real M Ringgit

12/2012 106.56 97.31 96.89 101.16 84.96 101.46

01/2014 115.62 101.19 103.66 82.23 78.28 98.17

07/2014 111.52 100.49 102.58 83.88 84.65 101.19

07/2015 127.46 115.58 93.67 75.07 65.49 93.35

Change since

12/2012 +19.6% +18.8% -3.3% -25.8% -22.9% -8.0%

01/2014 +10.2% +14.2% -8.7% -10.5% -23.1% -7.6%

Source: BIS, www.bis.org, and computation thereof

By December 2012, the RMB exchange rate should have already been within an equilibrium range, judging from both the current account surplus as a percentage of GDP and trade surplus as a percentage of total trade volume. However, by last month, its REER rose by 19.6% over this period, hitting the record level since January 1994, when BIS REER was first recorded, compared to the dollar's 18.8% rise. The euro, yen, Brazilian real and Malaysian ringgit all fell considerably during the same period. As a result, the RMB rose by 0.7% to the dollar, 23.7% versus the euro, 61.2% vs. the yen, 55.1% vs. the Brazilian real and 30.0% vs. the Malaysian ringgit. Apparently, RMB's REER had deviated from its equilibrium level and needed a downward correction by the market.

After the recent fall, the RMB has only depreciated to the dollar, but still appreciated considerably against other major currencies. The REER of the RMB is based on a number of major currencies, with the largest weights from the euro, followed by the dollar and then the yen. Therefore, it is impossible for the RMB REER to follow the dollar REER. The current RMB fall compared to the dollar is an issue of the dollar's strength, rather then RMB weakness, if any.

The rises and falls are daily normal in world currency markets. There is no complaint about the euro's fall. The euro could exchange for $1.46 in 2008, and $1.30 last year, but hovers currently around $1.10, with Goldman Sachs' forecasting parity by the year end. The yen fell even more against the dollar, from 83 in 2010 to a recent close at 120. Again, there is no complaint. Why a fuss over the RMB?

The fundamental explanation for the RMB's fall to the dollar is not about the RMB, because its REER is still exceptionally high, but with the dollar, which is too strong. The nominal exchange rate index of the dollar to major currencies stood at 91.6450 for July 2015, while it was 77.1141 for January 2014, or 24.5% up over 19 months. Apparently, RMB should not follow the dollar's exchange-rate level.

However, the past 42 years since the de-pegged from gold have shown the dollar's own cycles, with subsequent rises and falls. Interestingly, during an earlier 19-month period from March 2009 to October 2010, it fell by 14.0%. Again, there was no complaint from the US congressmen.

It can be anticipated that, with the FED interest-rate hike still pending, the dollar will continue to strengthen in the coming months, leaving room for the RMB to fall further from the dollar. Due to the economic fundamentals in China, the RMB's drop will be limited: It will still be reasonable if the RMB falls to 6.50-6.60 to the dollar by the year's end. However, with the dollar's strength fully developed, a new phase of dollar's fall will follow. During that period, RMB will most probably rise again to 6.40, 6.30 or even 6.20 to the dollar.

Exchange Rate Has Little Impact on China-US Trade

The growth curve of China-US bilateral trade over the past 8 years does not show any strong linkages between the RMB/dollar exchange rates and the bilateral trade performances.

Ironically, according to the US ITA official trade statistics, the appreciation of the RMB to the dollar has helped Chinese exports to the US. When RMB was pegged again to the dollar in 2008, Chinese exports to the US grew more slowly (by only 5.1%, compared to 7.5% growth in the world exports to the US). During the period of 2010-2014 when RMB floated again and appreciated to the dollar, Chinese exports to the US grew faster than to the rest of the world (57.5%:50.5%). During the first half of 2015, when the RMB was as strong as the dollar, Chinese exports to the US still grew by 5.9%, while the rest of the world saw a 3.4% decline.

As regards US exports to China, there has been a fast weakening in its growth momentum over the past 18 months. In 2014, US exports to the world grew by 2.7%, but grew by a mere 1.6% to China. During the first half of 2015, US exports to China declined by 4.5%, approximately the same rate as its exports to the world (off 5.2%). The reason of its exports to China could be found, to a large extent, in the sharp fall of agricultural exports, which fell by $ 1.01 billion, 38.4% of the total net decline, while its exports of transportation equipment, computer and electronics, and chemicals combined grew by $ 450 million. The four categories shared the same exchange rate but had drastically different performances. Hence, the figures cannot be explained by the RMB exchange rate. According to official Chinese trade data, the value of its soybean imports (predominantly from the US) during the Jan.-July period fell by 19.6% over a year ago, although the import quantity grew by 7.0%. The reason is apparently the sharp fall of soybeans prices in the world market. It can also be demonstrated by the similar pattern of US agricultural exports to the world, which fell by $ 12.09 billion over the first half of 2015, accounting for 28.9% of the total net export decline.

In conclusion, the primary factor affecting China-US bilateral trade performance is the trade structures and world commodities market, rather than the exchange rates between the RMB and the dollar. The two nations and business communities should focus on identifying the complementary sectors and products of the two countries and seeking a sustainable pattern of stable growth based on mutual benefit.